What Kind of Caution by the Fed This Time?

Monday

When Federal Reserve policy makers meet on Wednesday to set interest rates, they will be paying less attention to what is happening to the economy than to what could happen.

WASHINGTON, Oct. 28 — When policy makers at the Federal Reserve set interest rates on Wednesday, they will be paying less attention to what is happening to the economy than to what could happen.

Except for deepening problems in the housing market, much of the American economy shows surprising strength and little need for a boost from cheaper loans.

The Commerce Department is expected to report Wednesday that the economy grew by at least 3 percent in the most recent quarter ended in September. That would meet what economists consider the nation’s natural growth rate. Consumers have kept spending, companies have kept hiring and exports are climbing at double-digit rates.

All of that has happened even though financial markets have been volatile since early in August, when troubles arose in the mortgage market.

But investors now seem convinced that the Federal Reserve, after two days of meetings that start Tuesday, will lower the benchmark federal funds rate by a quarter of a percentage point, to 4.5 percent, and Fed officials have done nothing in recent speeches to tamp down those expectations.

Rather, Fed officials have stressed their inclination to act pre-emptively against the possibility of a serious downturn. Instead of pointing to actual weakness in the broad economy, they have focused on worries that the deepening fall in housing prices and the fears running through the credit markets pose dangers that ought to be addressed.

A blunt analysis came from Frederic Mishkin, a Fed governor, speaking at the Fed’s symposium in Jackson Hole, Wyo., on Sept. 1. In a dense and detailed analysis of how housing troubles could affect the rest of the economy, Mr. Mishkin estimated that a hypothetical 20 percent drop in housing prices by the end of 2008 could cause total economic output to shrink by as much as 1.5 percent within three years.

Based on that analysis, Mr. Mishkin seemed to argue that the central bank should react to that kind of downturn in housing prices by lowering rates more rapidly than traditional Fed models might suggest.

“Monetary authorities have the tools to limit the negative effects on the economy from a house-price decline,” Mr. Mishkin told the conference.

It is unusual for Fed officials to make a direct link between monetary policy and asset prices — whether for real estate, stocks or commodities like oil, gold and silver. For policy makers, the core issues are consumer price inflation and economic growth.

But the Federal Reserve chairman, Ben S. Bernanke, has said that declining house prices could interact with problems like the turmoil in the credit markets to derail other parts of the economy.

In a speech Oct. 19 on “monetary policy under uncertainty,” Mr. Bernanke argued for acting sooner rather than later when risks become apparent.

“Intuition suggests that stronger action by the central bank may be warranted to prevent particularly costly outcomes,” he told listeners at a conference sponsored by the Federal Reserve Bank of St. Louis.

Mr. Bernanke went on to argue that central banks should sometimes depart from a cautionary principle, first enunciated by the economist William C. Brainard, that central banks have embraced for years.

Mr. Brainard said that a central bank, when confronted with heightened risks in the economy, should react with small steps first and base future measures on the results that follow. If a feared downturn failed to occur, for example, a small reduction in interest rates would be less likely to stoke future inflation.

But Mr. Bernanke maintained that economists had made “substantial progress” over the last decade in analyzing real-time economic data. A wide body of research, he said, suggested that the Brainard principle of caution “may not always hold.”

That view has been echoed by other officials. Charles L. Evans, president of the Federal Reserve Bank of Chicago, said declining house prices could lead to a slowdown in consumer spending, more mortgage delinquencies, more trouble in financial markets and “serious downside risks” to the overall economy.

“I want to emphasize that I do not see this extreme outcome as likely,” Mr. Evans said in a speech last week at the University of Chicago. “But it is one of those high-cost outcomes that we should guard against.”

That would be in line with the approach promoted by Alan Greenspan, Mr. Bernanke’s predecessor. But analysts say this mind-set has a tough corollary that Fed officials have not followed as carefully: if the trouble fails to materialize, the central bank has to take back its generosity and raise interest rates as assertively as it cut them.

Most economists say Mr. Greenspan was correct to reduce interest rates as the economy slid into recession in 2001. But a growing number of experts, including Mr. Evans of the Chicago Fed, contend that the Fed waited too long before it started to raise rates again in June 2004.

Many Fed officials also see a cautionary tale in how the Fed responded to fears in 1998 caused by Russia’s financial breakdown and the collapse of Long Term Capital Management, a major hedge fund company.

Much as today, credit markets began to freeze up in fear. The Fed initially held back from any direct action, and then cut rates less than many in the financial markets hoped. Then it surprised investors with a big rate cut at an unscheduled meeting.

As it happened, the credit panic calmed down, and the American economic boom continued. But it was not until June 1999 that the Fed began to take back its rate cut, a delay that provoked some fear of inflation.

“The first lesson was that if you’re going to be a firefighter, be sure you bring enough water,” said Vincent R. Reinhart, a former adviser to Mr. Greenspan and Mr. Bernanke and now a fellow at the American Enterprise Institute. As for the second lesson, he said, “As any insurance adjuster will tell you, there can be more damage from the water than from the fire itself.”

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